Futures Dairy

8/16/2019 Futures Dairy

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Edward V. Jesse and Robert A. Cropp

A Guidebook for Dairy Producers

Futures and OptionsTrading in Milk and Dairy Products

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Introduction . . . . . . 1

Part I: Dairy futures contracts

What is a futures market? . . . . 2

How and why did futures marketsdevelop? . . . . . . . . 2

What are the commitments of buyersand sellers of futures contracts? . . . 3

Who are the key players in a futuresmarket? . . . . . . . . . 3

What is the procedure for tradingfutures contracts? . . . . . . 3

What keeps traders from walking awayfrom their contract obligations? . . . 4

Who accounts for futures contracttransactions and margin requirements? . 4

How are futures markets regulated? . . 5

What criteria does the CFTC use toevaluate new futures contracts? . . . 5

What do the dairy futures contractslook like? . . . . . . . . 6

Why the interest in dairy futurescontracts? . . . . . . . . 6

How can futures trading reducemarket price risks? . . . . . . 8

How can dairy farmers use futurestrading to reduce risk? . . . . . 9

What makes up the basis in a dairyfarmer hedge? . . . . . . 10

What’s the best way to forecast basisin a Class III hedge? . . . . . 12

Can I get out of a futures contractafter I’ve placed a hedge? . . . 12

When would I want to use a longhedge? . . . . . . . . 13

How is hedging used in cash forwardcontracting? . . . . . . 13

Part II:Options on dairy futures

What are futures contract options? . 14

What does it cost to buy a futurescontract option? . . . . . 15

Aren’t call and put options just twosides of the same coin? . . . . 16

What do the options on dairy futureslook like? . . . . . . . 17

How can options be used forhedging price risk? . . . . . 18

How are options used in a oorprice cash contract? . . . . . 19

How do I pick the best riskmanagement tool? . . . . . 20

What can I use to help me formulategood price forecasts? . . . . 21

Appendix I:Hedging examples . . . 22

Appendix II:Advanced strategies . . 26

Contents


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Futures and Options Trading in Milk and Dairy Products —A Guidebook for Dairy Producers 1

Introduction The opportunity for dairy farmers,dairy processors, and marketing rmsto engage in price risk management

through futures and options trading isa fairly recent development. The Coffee,Sugar and Cocoa Exchange (CSCE, nowpart of the New York Board of Trade, orNYBT) offered the rst modern dairyforward pricing contracts, for cheddarcheese and nonfat dry milk, in 1993. 1

Despite limited trading of the new dairycontracts, the CSCE introduced a Class IIIuid milk contract in 1995. The ChicagoMercantile Exchange (CME) started itsown uid milk contract in the same year.

Both exchanges terminated their(deliverable) uid milk contracts in1996 and began trading cash-settledBasic Formula Price (BFP) contracts.During the same year, the CME addeda deliverable contract for butter, and,later, cash-settled contracts for cheddarcheese (1997), nonfat dry milk (1998),and dry whey (1998). In 2000, the BFPcontracts were converted to Class IIImilk contracts to conform to federalmilk marketing order pricing changes

instituted on January 1. Later in 2000, theCME introduced futures contractsfor Class IV milk.

The NYBT terminated trading in dairycontracts in June 2000, leaving the CMEas the only exchange listing dairy-relatedfutures and options contracts. The CMEdiscontinued trading cheddar cheesefutures and options but continues totrade Class III, Class IV, deliverable butter,nonfat dry milk, and dry whey contractsand added a cash-settled butter contract

in 2007. That same year, the CME mergedwith the Chicago Board of Trade and isnow referred to as the CME Group.

As price volatility for milk and dairyproducts has increased in recentyears, interest in trading dairy futuresand options contracts has increasedcorrespondingly. In late 2000, openinterest in the CME Class III contract, themost actively-traded contract within theCME dairy complex, was about 10,000contracts. Open interest in Class III putand call options totaled about 3,000.In mid-2008, open interest in the ClassIII futures contract exceeded 25,000contracts and open interest in Class IIIput and call options exceeded 16,000. The CME deliverable butter contract hasshown minimal trading activity, but thecash-settled butter contract had open

interest of nearly 3,000 contracts in mid-2008. Open interest in the dry whey andnonfat dry milk contracts was about2,000 and 700 contracts, respectively.

While trading in dairy contracts remainssmall in comparison to major grainand livestock futures contracts, 2 dairyfutures markets are clearly here to stay.Hence, dairy farmers, milk buyers, andothers have an excellent opportunityto manage price risk through the useof futures, options, and futures-based

forward pricing contracts.In this publication we address somebasic questions concerning futures andoptions markets and the mechanicsof trading from the perspective ofthe dairy farmer. We provide severalillustrations showing how dairy farmersmight use futures trading—directly andindirectly—to hedge price risk.

1 The Chicago Mercantile Exchange traded a butter futures contract for many years in the early 1900s. In fact, the CME began in the late 1800sas the Chicago Butter Exchange, a wholesale cash market for butter, and later added cash and futures contracts for butter and several otheragricultural commodities. The butter futures contract was terminated in the early 1960s because of limited trading volume.

2 Daily trading volume in corn and soybean futures on the Chicago Board of Trade is typically several times the volume of open interest indairy contracts.

Dairy farmers

and others have

an excellent

opportunity to

manage price risk

through the use of

futures, options,

and futures-based

forward pricingcontracts.


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2 Futures and Options Trading in Milk and Dairy Products

Part I provides some basic backgroundinformation on futures contracts,including history, regulatory procedures,and trading mechanics. Then, weillustrate some representative hedgesfor dairy industry participants usingthe Class III milk contract. Part II dealswith options trading. We show howoptions markets work in general anddemonstrate how dairy farmers mightuse options to protect pricing objectives. Two appendices provide additionalhedging examples and illustrate someadvanced price risk managementstrategies.

Part I: Dairyfutures contractsWhat is a futures market?Simply stated, a futures market is anorganized auction market for tradingfutures contracts; that is, contracts forfuture delivery of a commodity. A futuresmarket can be contrasted with a cashor spot market. A cash or spot marketprovides for immediate delivery of andpayment for the commodity traded. The

purpose is to fulll the immediate needsof buyers and sellers. There are informaland formal cash markets. An exampleof an informal market is the sale of drywhey through private negotiationsbetween sellers and buyers. The ChicagoMercantile Exchange daily cash marketfor butter is an example of a formalorganized wholesale cash market.

A futures contract involves acommitment to either accept or makedelivery of a specied quantity andquality of a commodity at a speciedtime, and often at a specied place ofdelivery. No actual commodity changeshands unless and until the contractcomes due, or matures.

With the exception of the deliverablebutter contract, dairy futures contractsare cash-settled rather than settledthrough delivery of the underlyingcommodity. With cash settlement,delivery is not even allowed as ameans of settling the contract. Rather,the commitment is to make up anydifference between the price at thetime of sale or purchase of the contractand the price at the time the contractexpires. For example, if a November ClassIII milk contract was sold at $15.00 perhundredweight and the announcedClass III price for November turned out tobe $16.00, the seller would cash settle bypaying $1.00 per hundredweight to the

buyer of the contract. 3

Cash settlement makes it easier to tradecontracts because there is no needto have the physical commodity fordelivery. For the Class III and Class IVcontracts, cash settlement is essentialbecause the “commodity” is really areference price applied to a physicalvolume of standardized milk.

In addition to providing a physicallocation for trading futures contracts,futures markets also establish rulesof conduct, x contract specications,collect and distribute marketinformation, guarantee settlement ofcontractual and nancial obligations,and arrange for settlement of disputesamong traders.

How and why did futuresmarkets develop? The origin and development of futuresmarkets dates to the mid-19th century

with the expansion of market areas foragricultural products, particularly forgrain. Market price risk increased dueto the long time period between grainproduction, storage, and nal sale. Sellerswanted to protect themselves againsta loss in grain inventory value due toprice declines between harvest and sale.Initial attempts to avoid this price riskinvolved establishing a price for grainbefore it had arrived at its destinationthrough what were termed “to arrive”

contracts. This procedure passed pricerisk from the seller to the buyer, butmany grain dealers and processors wereunwilling to absorb all the price risk. The development of futures marketsalleviated the problem by sharing therisk of unfavorable price movements andthereby increased the ow of risk capitalinto the marketplace.

The rst organized futures market wasthe Chicago Board of Trade (CBOT). TheCBOT was founded in 1848 as a cash

grain market; it did not start futurestrading in grain until 1865. Today, thereare eight futures markets in the UnitedStates. Each of these futures marketsis operated by one of eight futuresorganizations, called futures exchanges.Futures markets also exist in many othercountries.

3 This is a simplistic explanation of cash settlement. In reality, the broker account of the seller would be debited and the account of the buyerwould be credited.


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A Guidebook for Dairy Producers 3

More than 100 different commoditiesare traded on U.S. futures markets. Earlyin their history, futures markets tradedonly agricultural commodities. Raw farmcommodities like corn, wheat, soybeans,cotton, cattle, hogs, sugar, cocoa, andcoffee still make up a large portion offutures market trading. But non-farmcommodities such as gold, silver, heatingoil, and plywood are also actively traded.And nancial instruments like Treasurybills, interest rates, and foreign currencieshave come to make up a majority shareof futures trading.

A major reason for the existence offutures markets is to provide a meansfor shifting the risk of price change onthe cash market for the commoditiesinvolved. This is accomplished througha process called hedging, which isexplained later. For hedgers, futuresmarkets are not places to buy and sellcommodities; they are used to protectprice and prot objectives in the cashmarket.

What are the commitmentsof buyers and sellers of

futures contracts?If the initial trade on the futures marketis the purchase of a contract, the buyeris said to be long in the market. Fora deliverable contract, the buyer haspurchased a commitment to receivedelivery of a commodity at a specicfuture date and at a specic price. If theinitial trade is the sale of a contract, theseller is said to be short in the market. The seller of a deliverable contract hassold a commitment to make delivery of

a commodity at a specic date and at aspecic price.

In nearly all cases, the buyers and sellersof the deliverable contracts will nothold the contracts until they mature.Instead they will cover their commitmentby offsetting positions on the futuresmarket with opposite transactions priorto contract maturity. Thus, the sellerof a futures contract (short) coversby purchasing a futures contract inthe same month prior to maturity ofthe contract. A purchaser of a futurescontract (long) would cover through thesale of a futures contract.

As noted above, most dairy futurescontracts are cash settled againstan announced U.S. Department ofAgriculture reference price. If theannounced price at contract maturity ishigher than the purchase or sale price,longs receive a payment equal to thedifference and shorts are obligated topay the difference. If the announcedprice is lower than the price at the timethe contract was purchased or sold,then longs pay and shorts receive thedifference. In terms of accounting, cashsettlement is equivalent to offsetting atthe time of maturity.

For deliverable futures contracts,commitments are legally enforcedby requiring actual delivery (shorts)and acceptance of delivery (longs) ofthe underlying physical commodityif a contract is allowed to mature. Forcash-settled contracts that are allowedto mature, the legal requirement isfor either buyers or sellers to make acash payment equal to the differencebetween the purchase/sales price andthe announced price, depending on theannounced settlement price relative tothe price at the time the contract wasbought or sold. Both deliverable andcash-settlement contracts can be offsetprior to maturity, thus removing the legalcommitment. When contracts are offset,there is a cash settlement representingthe difference between the purchaseand sale prices.

Who are the key playersin a futures market?Futures market traders are either hedgers or speculators . A hedger uses the futures

market to protect a cash market priceand prot objective. Hedgers deal inboth the cash and futures markets, buttheir interest in the futures market is as ameans of shifting price risk. Specically,hedgers expect that nancial losses inone market will be offset by gains in theother market.

Speculators assume the price riskthat hedgers try to avoid. The motiveof speculators is to make a protby advantageously trading futurescontracts (buy low and sell high orsell high and buy low). This greedymotivation should not be viewednegatively. Speculators provide thefutures market with an essential element,liquidity, which enables hedgers to buyor sell contracts when they want to setor lift their hedges. Absent speculators,short or long hedgers would have torely exclusively on each other to makeopposite transactions. Speculators buildmarket liquidity by bridging the gap

between the prices bid and offered byother commodity traders.

What is the procedure fortrading futures contracts?In order to trade on the futures market,you need to open an account andsign a customer agreement with alicensed broker knowledgeable aboutthe contracts you will be trading. Sincedairy futures contracts were introduced,many brokerage rms have developedconsiderable expertise in these contractsand how they can best serve customerneeds. The customer agreement willspecify whether your interest is inspeculating or hedging. The broker willcarry out your trade orders through aFutures Commission Merchant (FCM), arm registered to engage in trading onthe exchange oor. Many brokers areemployees of an FCM.


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A oor broker is a broker on theexchange trading oor who does theactual trading. The FCM places thecustomer’s order with the oor broker.Floor brokers may also take outsideorders from commercial interests,processors, exporters, and evenspeculators. Floor brokers should bedistinguished from locals. Locals are alsoon the exchange oor, but they tradeon their own account and speculate onfutures price movements.

Since 2007, CME dairy futures andoptions can be traded electronically 23hours a day using the GLOBEX system. Trading dairy futures on the CME tradingoor continues, but the addition ofelectronic trading expands the potentialtrading volume and the number oftrading participants. Trading on theCME oor starts at 9:30 a.m. and ends atapproximately 1:10 p.m. (Central time).Initial settlement prices are reported atapproximately 1:30 p.m. But with thecontinuation of GLOBEX trading, thenal daily settlement prices are reportedlater—at approximately 7:00 p.m.

What keeps traders fromwalking away from theircontract obligations?Buyers and sellers of futures contractsare required to post performance bonds ,often called margin deposits or margin .Margin represents a nancial guaranteethat buyers and sellers will fulll theirobligations of the futures contract,providing for contract integrity. Marginrequirements for futures contractsusually range between 5 and 15 percent

of a contract’s face value and are set bythe futures exchange where contractsare traded. The size of the marginrequirement depends in part on theprobability of a price change. A highermargin is required in a volatile (or risky)market than in a less volatile market.

Brokerage rms may require a largermargin than the futures marketminimum, but they cannot require asmaller margin. Margin requirementsmay be different for hedging andspeculating accounts. Typically, lowermargins are required for hedgingaccounts because they carry less riskthan speculating accounts. Margin maybe in the form of cash or governmentsecurities. 4

The performance bond margin postedby traders at the time they place anorder to buy or sell a futures contractis called initial margin . If prices move infavor of the trader (e.g., rising price for along position or falling price for a shortposition), then no additional margin isrequired. But if prices move unfavorably,then the loss that would be incurredif the contract were liquidated woulderode or eliminate the margin balance.If the margin falls below a maintenancemargin level, which is less than the initialmargin, then the trader will be obligatedto post additional margin to restore themargin to the initial level. The requestfor additional margin is referred to as amargin call .

Margin calls provide some assuranceagainst trader defaults. For example, ifthe price of a commodity increases, aseller of a futures contract could possiblygain by defaulting on the contract andforfeiting the initial margin. To preventthis from occurring, the seller is requiredto post enough additional marginto more than offset any gain fromdefaulting. Should a customer refuse tocome up with additional margin, his/herposition will be closed out by the brokerand the resulting loss will be deductedfrom the margin. If the remaining marginis not sufcient to cover the loss, thecustomer may be sued or subject toother penalties.

Just as every buyer or seller of a futurescontract must maintain adequate fundsin a margin account with the brokeragerm, so must each brokerage rmmaintain adequate funds in its marginaccount with the futures exchangeclearinghouse to cover the positions ofits customers.

Margins are returned to the sellerand buyer when the contract is offset(covered) by an opposite transaction orwhen the contract matures and deliveryor cash settlement occurs. When futuresprice movements favor the trader, themargin plus futures gain (prot) arereturned. If a trader experiences a loss onthe futures contract trade, then the lossis deducted from the margin and theremaining margin is returned.

Who accounts for futurescontract transactions andmargin requirements?Essential to each futures exchange isa clearinghouse. Clearinghouses areresponsible for day-to-day settlementsof thousands of accounts andtransactions, collecting and maintaining

margin monies, regulating delivery, andreporting trading data. Their operationsinsure the nancial integrity of themarketplace.

Both buyers and sellers of futurescontracts are responsible to theclearinghouse through FCMs orbrokerage rms that are members ofthe clearinghouse. Clearinghouses actas third parties to all futures contracts—acting as a buyer to every clearingmember seller and a seller to every

clearing member buyer. Buyers andsellers of futures contracts do not createnancial obligations to one another butrather to the clearinghouse throughtheir clearing member rms. As a thirdparty to every trade, the clearinghouseassumes the responsibility of guarantorof every trade.

4 The advantage of using government securities as margin is that they earn interest for the customer at the same time that they serve as aperformance bond for the futures market position. Brokers seldom pay interest on cash margins. The disadvantage of using governmentsecurities as margin is that the denominations are large and “lumpy,” meaning that the performance bond may be much larger than required.Different rules pertaining to margin calls and prot payouts apply to margin deposits in cash and securities.


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Clearinghouses settle all accounts to anet gain or loss each trading day andbalance their own books to a net zeroposition, since gains must fully offsetlosses. Gains are credited to accountsof member rms or, in some cases, arepaid out to customers. Losses that erodemargin deposits below required levelsrequire prompt posting of additionalfunds.

How are futures marketsregulated?Futures exchanges in the United Statesare required by state and federal lawsto regulate the conduct of members,member rms, and their employees. The rules and regulations of futuresexchanges are extensive and aredesigned to support competitive,efcient, liquid markets. Exchangerules and regulations cover many areasof futures trading—from contractspecications to trading practices toarbitration procedures. For example,the exchange sets daily trading limitson the maximum price range allowedeach trading day for a contract. Positionlimits are set on the maximum numberof futures contracts that may be heldby a market participant. FCMs areliable for losses that occur due to erroror mishandling a customer’s order.Members who default on futurescontracts may be suspended.

The obligation of the exchanges toenforce their own rules and regulationswas expanded in the late 1900s withthe passage of several federal acts. Ofmost relevance today is the CommodityFutures Trading Commission Act of 1974and subsequent futures trading acts.Prior to the 1974 act, federal regulationof exchanges was through theCommodity Exchange Authority, whichwas housed in the U.S. Departmentof Agriculture and reported to theSecretary of Agriculture. The 1974act created an independent federal

regulatory agency, the CommodityFutures Trading Commission (CFTC). The subsequent futures trading acts re-authorized the continuation of the CFTCand claried its jurisdiction.

The CFTC has ve full-timecommissioners appointed by thePresident with Senate conrmation. The CFTC’s regulatory powers extend toexchange actions and to the review andapproval of futures contracts proposedby an exchange. The CFTC has regulatorypowers over oor brokers, FCMs, andother market participants. Exchangesand their clearinghouses are requiredby the CFTC to maintain daily tradingrecords. The CFTC is authorized to takeemergency steps in the markets undercertain conditions, such as actual orthreatened market manipulation orsome other event that prevents themarket from reecting true supply/demand factors.

In addition to federal and self-regulation,there is industry regulation. TheCommodity Futures Trading CommissionAct of 1974 authorized the futuresindustry to create registered futuresassociations with the CFTC. One suchorganization is the National FuturesAssociation (NFA). NFA is an industry-wide, industry-supported, self-regulatoryorganization for the futures industry.NFA enforces ethical standards andcustomer protection rules, screensfutures professionals for membership,and credits and monitors futuresprofessionals for nancial and generalcompliance rules and related activities.

FCMs and brokerage rms providefurther regulation. Since they areresponsible to the exchange andclearinghouse for their customers’transactions, they do a completeinvestigation of the nancial integrity ofthe customer prior to opening a tradingaccount.

What criteria does theCFTC use to evaluate newfutures contracts?An exchange that wishes to trade a newfutures contract must request approvalfrom the CFTC. Prior to this request, theexchange will have studied the feasibilityof the proposed contract and receivedapproval from its board of directors. The CFTC must determine that a futurescontract is in the public interest. Inmaking this assessment, the CFTCexamines how the proposed contractwould be used commercially for pricingand hedging to ensure that it will servean economic purpose.

The CFTC is concerned about thenumber of market participants, bothbuyers and sellers, interested in hedging.Even more critical is the adequacy ofspeculator interest. As mentioned earlier,hedging will not work without sufcientspeculator activity, which is required formarket liquidity so a hedger may set orlift a hedging position in a timely fashion.


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What do the dairy futurescontracts look like?Futures contracts are standardizedcontracts. That is, there are no

negotiations over contract specications;the only variable is price. Major contractspecications for the dairy futurescontracts trading in June 2000 areshown in table 1.

Table 1 introduces some contractspecications-related terminologythat should be explained. The tradingunit is the size of the contract—ifyou sell a CME Class III milk contract,for example, you are in effect selling2,000 hundredweight of milk, and thevalue of that contract is 2,000 timesthe contract price per hundredweight. The prices for the Class III contracts arequoted in dollars per hundredweight. The minimum price uctuation , or “tick,”is one cent per hundredweight, which

translates to $20 per contract. The daily price limit is how much the price canmove up or down in a trading sessionbefore trading is suspended for the day.Price limits are designed to preventpanic trading situations in responseto strong upward or downward pricepressures. They give traders time to cooloff and reassess the supply and demandsituation in a less stressful environment.

All contracts except deliverable buttertrade in every month. Position limits referto the maximum number of contractsthat any one trader can hold. In general,these limits are designed to preventprice manipulation through squeezingor cornering the market (forcingabnormal price movements by holdinglarge proportions of both futures openinterest and deliverable supply). Positionlimits are less important in contracts thatare cash settled.

Why the interest in dairyfutures contracts?For the rst 40 years following itsinception in 1949, the federal milk price

support program protected the dairyindustry from price volatility. Underthe support program, the supportlevel for milk used for manufacturingwas set according to legislative rules. The announced support price wasmaintained by government purchases ofcheddar cheese (40-pound blocks and500-pound barrels), nonfat dry milk, andbutter at specied prices through theCommodity Credit Corporation (CCC).

Until the late 1970s, the federal dairyprice support program worked muchlike a buffer stock program. When milkproduction increased seasonally duringthe spring, CCC purchases would preventcheese, nonfat dry milk, and butterprices—and, in turn, manufacturing milk

Futures contractTrading

unitPricequote

Minimumpriceuctuation

Dailypricelimits* Months

Positionlimits* Last trading day

Settle-ment

Class III milk(2,000 X USDA Class IIImilk price)

2,000 cwt. $/cwt. $0.01/cwt. $0.75/cwt. All 1,000 contractsin any contractmonth

Business daypreceding Class IIIprice announcement

Cash

Class IV milk(2,000 X USDA Class IVmilk price)

2,000 cwt. $/cwt. $0.01/cwt. $0.75/cwt. All 1,000 contractsin any contractmonth

Business daypreceding Class IVprice announcement

Cash

Nonfat dry milk (44,000 X USDA monthlyweighted U.S. averageprice per pound fornonfat dry milk)

44,000 lbs. $/lb. $0.00025/lb. $0.025/lb. All 1,000 contractsin any contractmonth

Business daypreceding USDArelease date formonthly average U.S.nonfat dry milk price

Cash

Dry whey (44,000X USDA monthly

weighted U.S. averageprice per pound for drywhey)

44,000 lbs. $/lb. $0.00025/lb. $0.040/lb. All 1,000 contractsin any contract

month

Business daypreceding USDA

release date formonthly average U.S.dry whey price

Cash

Deliverable butter (Grade AA “fresh” orstorage butter)

40,000 lbs. $/lb. $0.00025/lb. $0.05/lb. Mar., May,July,Sept., Oct.,Dec.

1,000 contractsin all contractmonthscombined

Business daypreceding the lastseven business days ofthe contract month

Delivery

Cash-settled butter (Grade AA “fresh” orstorage butter)

20,000 lbs. $/lb. $0.00025/lb. $0.05/lb. All 1,000 contractsin any contractmonth

Business daypreceding USDArelease date formonthly average U.S.butter price

Cash

*Price and position limits can be expanded in the last month of trading.

Table 1. Dairy futures contract specications


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prices—from falling far from supportlevels. Then, during late summer andfall, when milk production was normallyat its seasonal low and demand wasrelatively strong, the CCC would sellcheese, nonfat dry milk, and butter backinto the commercial market. This addedsupply kept dairy product prices andmanufacturing milk prices from risingsharply during the fall. The CCC purchaseand sale activities provided stability andremoved much of the market price risk.

From 1949 to 1981, the support level formanufacturing milk was set between75 and 90 percent of parity. Underthe parity formula, the support pricemoved up slowly for the rst 20 years,going from $3.05 per hundredweightin 1950 to $4.60 per hundredweightin 1970. But between 1970 and 1980,the support price increased from$4.60 per hundredweight to $13.10per hundredweight. Dairy farmersresponded with increased milkproduction. By the late 1970s and early1980s, the level of milk surpluses andCCC purchase costs were deemedunacceptable by Congress.

The parity method of setting thesupport price was abandoned in 1981,and through a series of Congressionalactions, the support price was tied toactual or projected CCC purchase costs.From 1981 to 1990, the support pricewas reduced eight times, to $10.10 perhundredweight. The 1996 Farm Billelevated the support price to $10.35 in1996 and then lowered it by 15 centsper hundredweight per year downto its current level of $9.90. The 1996Farm Bill also called for terminationof the support program at the endof 1999, to be replaced by a recourseloan program for manufactured dairyproducts. Subsequent legislation

retained the support program. The 2008Farm Bill changed the support programfrom supporting the price of milk tosupporting the prices of cheddar cheese($1.13/lb. for block cheese; $1.10/lb.for barrel), nonfat dry milk ($0.80/lb.),and butter ($1.05/lb.). This effectivelyreduced the related support price forClass III milk to $9.33/hundredweightbased on federal order pricing formulasin effect on October 1, 2008.

The current CCC purchase prices forcheddar cheese, nonfat dry milk, andbutter offer only a very low safety netto farm milk prices. Since 1990, productprices and, in turn, manufacturing milkprices have been above support levelsmost of the time due to market forces. The federal dairy price support programno longer provides for price stability orassumes much of the market price risk.

With the market driving prices insteadof the government, price volatilityincreased markedly (gure 1). From 1965to 1985, the average annual standarddeviation of the principal milk priceindicator, the Minnesota-Wisconsin priceseries, was 30 cents per hundredweight,ranging from 4 cents to 94 cents. Inonly 4 of the 21 years did the standarddeviation exceed 50 cents.

From 1989 through 1999, the averageannual standard deviation of themonthly Minnesota-Wisconsin price(replaced by the Basic Formula Pricein 1995) was $1.16, ranging from 64cents to $2.45. Month-to-month milkprice changes of $1.00 to $2.00 becamecommonplace in the 1990s. In 1999, theBasic Formula Price dropped by $6.00 (34percent) between January and Februaryand $4.77 between September and

Figure 1. Market and support prices for milk

$ / c w t .


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October. Price increases of more than$2.00 were experienced in two monthsof 1999.

Milk price volatility increased even morein the rst decade of the 21 st century.Between 2000 and 2007, the averageannual standard deviation of the ClassIII price was $1.57, with a range of$0.45 to $2.68. Month-to-month pricechanges ranged from –$3.29 to $5.17. The monthly Class III price increased bymore than $2.00 per hundredweight vetimes and decreased by more than $2.00three times.

Sharply increased price volatilitycreates both opportunities and threats

for milk producers and milk buyers.Opportunities come from the higherprice peaks that volatili ty brings. Whenthe federal price support programwas active, price increases were heldin check by the presence of largegovernment stocks for potential releaseinto commercial markets. Recent historyhas shown clearly that price rises are nolonger constrained.

But volatility requires close attention tonancial planning during price troughs.

Milk is produced and marketed everyday. Dairy farmers do not have theopportunity to hold their milk in hopesof a better price day. Even temporarylow price troughs can create cash owproblems and, if low prices continuelong enough, the viability of the dairycan be jeopardized.

Milk buyers face similar challenges.Sharp run-ups in cheese prices meanthat cheesemakers can benet fromselling high-priced cheese made from

low-priced milk. But cheesemakersmake cheese nearly every day fromthe milk shipped to them daily by theirpatrons. Inventory values can depreciaterapidly with price declines. When milk isprocured at a high price to make cheesethat is subsequently sold at a bargainbasement price, the manufacturer’sability to pay patrons is diminished.

How can futures tradingreduce market price risks?Futures markets may be used to reducemarket price risk through hedging. In a

simplistic sense, hedging involves using afutures market transaction as a substituteor proxy for a cash market transactionthat will occur in the future. Thehedger sells or buys futures contractscomparable in volume to anticipatedcash market sales or purchases sometimelater in time. 5 This futures market sale orpurchase is made in an attempt to “lockin” the price of the futures contract asthe price for the future cash market sale.In this sense, hedging is an alternative

to entering into a cash forward contractwith a specied price.

Let’s look at some generalized examples.A manufacturer may hedge in anattempt to lock in the cost of a rawmaterial used in the manufacturingprocess. This calls for a long hedge.On the cash market, the manufacturerexpects to purchase a certain volumeof raw product sometime in thefuture. To lock in a price objective, themanufacturer will buy a futures contract

for the same or similar raw product priorto the time the cash market purchasewill be made. The futures contract monthchosen will be as close as possible to thetime the purchase will take place. Later,when the raw material is purchased, thelong position on the futures market willbe covered or offset by the sale of anidentical futures contract. Any loss froma price increase for raw material wouldbe offset by a comparable gain on thefutures market as long as the predicted

relationship between cash and futuresmarket prices holds . On the other hand, ifcash market prices fall, there would befutures market losses that would offsetthe cash market gains. In either case, themanufacturer realizes the raw materialcost objective that was sought at thetime the hedge was placed.

The relationship between cash andfutures prices is called basis , which isdiscussed in more detail later, in relationto dairy farmer hedges. Cash and futuresmarket prices for the same commoditydo not always move together. But theywill converge , or come together, as thedelivery date for the futures contractapproaches. For futures contracts thatinvolve delivery, convergence is assuredthrough arbitrage between cash andfutures markets.

To illustrate arbitrage, suppose the cashprice for a commodity was well belowthe futures price for exactly the samecommodity a few weeks before thedelivery date on the futures contract.Arbitragers would buy cheap (thephysical commodity) and sell dear(the futures contract). This would bidup the cash price and pull down thefutures price, thus causing convergence.If the cash commodity were tradingat a premium to the futures contract,opposite arbitrage transactions wouldsimilarly pull the prices together.

For cash-settled futures contracts,convergence is not an issue because it isguaranteed by denition. Cash-settledcontracts are settled against the actualcash price announced at the expirationof the futures contract.

Holders of inventory stand to incurlosses from price declines. The inventoryprice risk may be reduced by a shorthedge, initially taking a short (sell)position on the futures market. Later,when the inventory is actually soldon the cash market, the short positionwould be covered by a purchase of thesame futures contract sold earlier. Ifprices fell, causing a decline in inventoryvalue, the loss would be offset by a gainin the futures market from selling at aprice higher than the purchase price. Ifprices rose, the cash market gain fromhigher inventory value would be offsetby futures market losses (sale at a pricelower than the purchase price).

5 The futures contract volume and the cash market volume do not have to be identical in a hedging transaction. In fact, hedgers will usuallysell or buy futures contracts that total less than their expected cash market sales or purchases. Futures contract volume in excess of expectedcash market volume represents speculation in the futures market.


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A wholesaler could use hedging to offera cash forward contract for its productat a specied price. The market risk isthat the seller will experience greateracquisition costs than anticipated andlosses or reduced prots would occurwhen the forward-contracted price isreceived. To protect the seller’s protobjective from forward pricing, theseller would hedge by initially taking along position; that is, buying a futurescontract. Later, when the product isacquired and delivered (sold) on thecash market at the forward-contractedprice, the seller would offset (sell) thefutures contract. If product costs hadincreased (decreased), the loss (gain) in

the cash market by selling at the forwardprice would be offset by a gain (loss) inthe futures market.

Both long and short hedges may beused together to protect manufacturingmargins. For example, a food processorcould attempt to protect a prot marginobjective by locking in both ingredientcost and nished product price. Theinitial futures transactions would be along position for ingredients and a shortposition for nished product. Similarly,

a dairy farmer might protect an incomeover feed cost objective by selling milkfutures and buying corn and soybeanmeal futures.

The above discussion may lead oneto believe that losses (gains) in thecash market are exactly offset by gains(losses) on the futures market and thatthe price objective is exactly realized.More likely, the net price result will belower or higher than the objective. Itall depends upon what happens to thebasis. The basis is the difference betweenthe cash price of a commodity and theprice of the same or a similar futurescontract. For purposes of hedging, basisis predicted when the hedge is placed,and the actual basis may be differentwhen the hedge is lifted.

Basis is calculated by subtractingthe futures price from the cash price. Therefore, if the cash price is higherthan the futures price, then the basisis positive. If the futures price is higherthan the cash price, then the basis isnegative. Regardless of whether i t ispositive or negative, basis is said tostrengthen if the cash price rises relativeto the futures price and weaken if thecash price falls relative to the futuresprice.

Knowing basis and understanding whatcauses it to vary is essential for successfulhedging. In hedging transactions, theprice or prot objective will differ fromits expected value by any differencebetween the expected basis and theactual basis when the hedge is lifted or(for cash-settled contracts) when thecontract expires. For example, supposethat in a short hedge, a butter wholesaleseller expects the local cash marketprice for Grade AA butter will be 5 centshigher than the CME butter futures price(+5-cent basis) when the hedge is lifted.If the basis strengthens by 5 cents (thecash market price is 10 cents per poundhigher than the futures price), the net

price will be above the price objectiveby 5 cents. If the basis weakens by 5cents (cash market price equal to futuresmarket price), the net price will be 5cents below the price objective. For along hedge, the opposite effects occur;the net price is exceeded when the basisweakens and is not achieved when thebasis strengthens.

Hedging reduces market price risk, butbasis risk—the risk that the basis willdiffer from what was predicted whenthe hedge was placed—always exists.However, basis is usually easier toforecast than price; hence, basis risk isusually less than price risk.

How can dairy farmersuse futures tradingto reduce risk?We have talked generally about howfutures trading can be used to shiftrisk from cash market participants tospeculators. Now, let’s look at a specicexample of how a dairy farmer mighthedge to “lock in” a farm milk price. We’lluse the CME Class III milk contract in theexample.

Dana Dairy produces about 200,000pounds of Grade A milk per month.Dana ships milk to Bigcheese Coop,which operates a single cheese factory

regulated under the Upper Midwestmilk marketing order. In May 2008,Dana notes that the November 2008Class III milk contract is trading at$18.20. Looking back over the past veyears of milk checks, Dana sees thatfor November, the average basis—thedifference between Dana’s farm “mailboxprice” and the Class III price—was $1.30per hundredweight. So adding this basisto the November Class III price gives amailbox price of $19.50.

That’s high enough to cover basic costsof production and generate a reasonableprot. Dana’s study of dairy outlookinformation for the fall is sobering: Itlooks to Dana like the Class III price inNovember will be even lower than thecurrent November futures contract price.So Dana decides to hedge in order toprotect the predicted farm milk price of$19.50.

Dana’s hedge involves sell ing oneNovember Class III price contract

at $18.20. The contract trading unitof 200,000 pounds matches Dana’sexpected November milk sales. Dana’sbroker arranges the sale and charges a$100 commission. Converted to a costper hundredweight, the commission isa nickel, reducing the price objective to$19.45. Dana also deposits a requiredperformance bond (margin) of $2,000.


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Now, let’s see what happens whenNovember rolls around. We’ll look attwo cases. In the rst case, let’s supposethat Dana’s pessimistic forecast aboutNovember milk prices materializes. USDAannounces the November Class III priceat $16.20 per hundredweight, which is$2.00 less than the price at which Danasold the November CME Class III contract.So in the cash settlement process, Dana’sbroker account is credited by $4,000(2,000 cwt. X $2.00/cwt.).

The expected $1.30 basis holds, andDana sells November milk at $17.50.Adding the $2.00 of futures market gainto the cash market price and subtractingthe futures commission yields $19.45.Dana achieved the price objectivesought at the time the hedge wasplaced.

This sounds good, but what if anunanticipated drought causes a milkshortage and a run-up in prices inNovember? In the second case, theNovember USDA Class III price isannounced at $20.00. Dana sold theNovember CME Class III price contract at$18.20, meaning that cash settlement ofthe November futures contract resultsin a margin account debit of $3,600[($18.20 – $20.00) X 2,000 cwt.].6 But,assuming the expected $1.30 basisholds, Dana can sell milk in November for$21.30 per hundredweight. Subtractingthe futures loss and the commissionfrom the cash market milk price againyields $19.45, the price objective.

Looking at both cases, Dana Dairy haslocked in a November net farm milk priceof $19.45 per hundredweight, regardlessof which way the market moves. Whenthe market moved lower, futures marketgains offset cash market losses. Danawas pleased with the result becausenot hedging would have resulted ina $0.95 lower price. When prices rose,cash market gains offset futures market

losses. Dana was less pleased with thatresult. Even though the price objectivewas achieved, not hedging would haveyielded a net price $1.85 higher. Lockingin a price through hedging means justthat. You benet by protecting yourselffrom disadvantageous cash marketmoves, but at the same time, you can’tbenet from advantageous cash marketprice changes.

Perceptive readers may already havenoticed that we have stacked the deckin these two examples by assuming thatthe basis at settlement was the sameas what was expected at the time thehedge was placed. If the relationshipbetween cash and futures prices isdifferent from what was expected, thenhedgers experience correspondinglosses or gains relative to their priceobjective.

Suppose that in the preceding case,Dana Dairy’s basis prediction of $1.30was too high—that Dana receivedonly $1.00 per hundredweight overthe announced USDA Class III pricefor milk sold in November. In that case,the basis weakened (the cash pricewas lower relative to the futures price). There is no difference in the futuresmarket gains and losses shown in theexample, but the cash market price is$0.30 per hundredweight less. So thenet price actually received will be lessthan the price objective by $0.30, theamount by which the basis weakened.Similarly, if the basis turned out to be$1.50 per hundredweight (i.e., the basisstrengthened by $0.20), then the actualnet price will be $0.20 higher than theprice objective.

What makes up the basisin a dairy farmer hedge? To answer that, we need a littlebackground on federal milk marketing

orders and how they affect farm-levelprices for Grade A milk. 7

Ten federal milk marketing ordersregulate Grade A milk plants in mostof the United States outside California,which operates its own state milk pricingsystem. Orders set minimum prices formilk and milk components according tohow they are used. This classied pricingsystem denes Class I milk as milk usedfor uid products, Class II as milk usedfor soft manufactured products, Class IIIas milk used for hard cheeses, and ClassIV as milk used to make nonfat dry milkand butter. Minimum prices for milk andcomponents within these classes are setusing product price formulas that relatemilk and component values to prices forspecied manufactured products: butter,cheddar cheese, nonfat dry milk, and drywhey.

Four of the ten orders price milk to dairyfarmers according to a “fat/skim” pricingmethod. Under fat/skim pricing, farmersreceive minimum prices per pound ofbutterfat and per hundredweight of skimmilk calculated as weighted averages ofbutterfat and skim milk values for thefour milk classes. The weights are thepercentage utilization of milk by classacross all handlers in the market. In threeof the four fat/skim markets, the primaryuse of milk is Class I.

In the other six federal milk marketingorders, dairy farmers are paidminimum prices for pounds of threemilk components rather than for milkvolume. The components are butterfat,protein, and other nonfat milk solids. The minimum component prices paid tofarmers are the same component pricesused in deriving the Class III price. Thesix orders using multiple component

6 Actually, the loss in futures contract value would have been made up with margin calls between May and November.7 Readers seeking a more comprehensive explanation of milk pricing under federal milk marketing can refer to Ed Jesse and Bob Cropp,

Basic Milk Pricing Concepts for Dairy Farmers, University of Wisconsin-Extension, Cooperative Extension, Bulletin A3379.


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pricing (MCP) generally utilize mostof their milk in manufacturing classes(Classes III and IV). The Upper Midwestorder, which includes most of Wisconsin,Minnesota, North Dakota, South Dakota,and the Upper Peninsula of Michigan,uses MCP.

Producers paid under MCP also receive aproducer price differential and, in four ofthe six MCP orders including the UpperMidwest, a somatic cell adjustmentexpressed in dollars per hundredweight. The producer price differentialrepresents the (usually) higher valueof milk used in Classes I and II and the(usually) lower price of milk used in ClassIV relative to Class III milk value. In effect,it is a weighted average value of thedifferences between the Class I, II, andIV prices and the Class III price with theweights dened as the market utilizationof milk in Classes I, II, and IV. The producerprice differential is adjusted for thelocation of the receiving plant within afederal marketing order relative to themajor consumption area.

The somatic sell adjustment is a qualitydifferential based on herd somatic cellcount (SCC) relative to a base of 350,000. The differential is positive if the SCC isbelow 350,000; negative if it’s above. The differential is fairly small, usually lessthan 15 cents per hundredweight.

To summarize, federal orders specifyminimum farmer payments for butterfat,protein, other solids, the producerprice differential, and the somatic celladjustment. On top of these federalorder payments, producers may receivepremiums or have certain deductionsfrom their plant that are not relatedto the order. Premiums may includeextra payments for protein and quality(separate from the minimum federalorder protein price and the somaticcell adjustment), plant premiums, andvolume premiums. Typical deductionsare for milk hauling, promotion andcooperative fees, and retains. 8

The link between the Class III price,which is the traded commodity infutures contracts, and a producer’sspecic mailbox milk check price isthrough the component prices forbutterfat, protein, and other solids. Thecomponent prices used to derive theClass III price are the same as the pricespaid to producers.

The Class III price is calculated formilk of standard composition—3.5pounds of butterfat per hundredweightand 96.5 pounds of skim milk. Thestandard composition for skim milk perhundredweight is 3.1 pounds of trueprotein, 5.9 pounds ofother nonfat solids, and91.0 pounds of water. Sothe component weightsin a hundredweight ofstandard milk are 3.5pounds butterfat, 2.99pounds of true protein(.965 X 3.1), and 5.69pounds of other solids(.965 X 5.9).

Figure 2 illustrates the relationshipbetween the Class III price andthe mailbox price. Note that if aproducer ships milk that has the samecomposition as the standard milk usedto derive the Class III price, then theproducer’s mailbox price will differfrom the Class III price by the total ofthe producer price differential, thesomatic cell adjustment, and the netplant-specic payments/deductions. If aproducer’s milk composition is differentfrom the standard composition usedto derive the Class III price (which is thecase in gure 2), then the basis will alsobe affected by the difference. Higher

8 Some producers may also have milk check assignments to nancial institutions and the cost of dairy supplies and other items deducted fromtheir milk checks. These are business expenses that are not included in calculating the mailbox price.

3.5 lbs. butterfatX butterfat price

2.99 lbs. proteinX protein price

5.69 lbs. othersolids X othersolids price

Producer lbs. ofbutterfat per cwt.of milkX butterfat price

Producer lbs. ofprotein per cwt.

of milk X proteinprice

Producer lbs. ofother solids percwt. of milk Xother solids price

Producer pricedifferential

SCC adjustment

Plant-specificpremiums lessdeductions

Federorderpaym

Basis

Figure 2. Basis in Class III milk hedging

Producermailbox price

Class III price


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butterfat and protein tests mean that thesum of the mailbox component valueswill be higher than the Class III price andvice versa.

Component tests and somatic cellcount are usually quite predictablefor any given month, and thus, do notcontribute much to basis risk. However,there is likely to be a distinct seasonalpattern to tests and cell count. Likewise,plant-specic premiums and deductionstypically show a distinct seasonalpattern. In particular, lower cheese yieldsin summer months for given butterfatand protein tests mean less money forplants to distribute as plant premiums.So it is important to consider thecontract month when estimating basisfor your hedge.

The most difcult part of the basis toforecast is the producer price differential(PPD). The PPD varies mainly with ClassI utilization and the Class I price relativeto the Class III price. Market Class Iutilization shows a seasonal patternbut changes slowly from year to year.However, the Class I price relative to theClass III price depends on how rapidlymanufacturing milk prices changefrom month to month. This difference is

unstable with the kind of price volatilityobserved in recent years.

Table 2 shows PPD averages by monthfor the Upper Midwest federal order.From January 2000 through December2007, the PPD for the Upper Midwestfederal order averaged $0.31 perhundredweight. The range was from alow of –$4.11 in April 2004 to a high of+$1.43 in November 2000. The marketexperienced negative PPDs 12 times inthis 84-month period. Because federalorders set Class I milk prices based onmanufacturing milk prices 6–7 weeksearlier, negative PPDs can occur withrapid increases in Class III or Class IV milkprices.

What’s the best wayto forecast basis in aClass III hedge? The best information to use inforecasting basis is history. Compareyour mailbox prices with the announcedClass III price for at least three years,preferably longer, but do not use yearsprior to 2000, when federal order pricingwas fundamentally changed. Calculate

average differences by month. Use therelevant month average difference as

a rough and ready estimate of basis toestablish your mailbox price objectivebased on futures contract prices. Youmay have more current information torene your estimate. For example, if yourecently brought some high-testingheifers into your herd and expect herdbutterfat and protein tests to be higherin November than the average for thelast ve Novembers, you can bump yourbasis estimate from the simple average.

A conservative approach is to usesomething less than the averagedifference between mailbox andClass III prices as your basis estimate.Remember that if the basis turns out tobe higher than the estimate you usedto gure your mailbox price objective(basis strengthened), you will exceedyour price objective. It is often betterto be pleasantly surprised than to bedisappointed.

Can I get out of a futurescontract after I’ve placeda hedge? The answer is “Yes, but….” You canalways lift a hedge once it has been

placed by taking the opposite position inthe same contract month. For example,if you placed a short hedge by selling aNovember Class III futures contract, youcan lift or remove the hedge by buyinga November contract. Your net gain/loss will be the difference between theselling price and the purchase price.

Lifting a hedge is a good strategy ifand only if it becomes apparent thatthe market is unquestionably movingagainst your futures market position.

Suppose you have sold a NovemberClass III contract for $16.00 in May, andit quits raining in June for three months. The November contract hits $17.00 inAugust, and USDA crop reports indicatecorn yields are expected to be downby 30 percent. That’s probably a goodsignal to cut your losses and lift yourhedge. You lose a dollar, but hangingon to a short position until November

Month

Median Mean Std. dev. Minimum Maximum

—dollars per hundredweight—Jan. 0.41 0.46 0.26 0.19 1.03

Feb. 0.47 0.39 0.32 -0.18 0.88

Mar. 0.55 0.47 0.24 0.05 0.78

Apr. 0.41 -0.14 1.63 -4.11 0.83

May 0.39 0.15 0.89 -1.97 0.90

June 0.34 0.40 0.31 -0.05 0.97

July 0.42 0.41 0.38 -0.41 0.80

Aug. 0.53 0.29 0.78 -1.58 0.84

Sept. 0.34 0.21 0.56 -1.07 0.70

Oct. 0.28 0.26 0.53 -0.88 0.86

Nov. 0.52 0.55 0.52 -0.07 1.43

Dec. 0.32 0.26 0.62 -0.95 1.23

Table 2. Upper Midwest producer price differential by month, 2000–2007


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could cost you a lot more. While $16.00may well have been a very good price atthe time you placed your hedge, alteredconditions mean that it no longer is.

The “but” part of the answer impliesa cautionary note. To repeat, hedgesshould be lifted only when it becomesapparent that prices are unquestionably moving against the hedger. Liftinga short hedge only to have pricesplummet can be very costly.

Experience from 2004 is illustrative. Atthe beginning of January 2004, July 2004Class III futures were trading around$12.80. By early February, July Class IIIfutures traded at $13.79, and by early

March, $15.44. Suppose that in earlyMarch, a dairy farmer hedged July milkby selling the July Class III contractat $15.44. July Class III futures pricescontinued to move higher, reaching$16.00 by mid-March. After receivingmargin calls, the dairy farmer decidesthat the July contract will continueto trade higher and decides to offsethis hedge, taking a loss of $0.56 perhundredweight ($16.00 – $15.44).

In fact, the July Class III futures price did

continue to increase, reaching $17.53 inApril. But then, growing milk and cheeseproduction resulted in an announcedClass III price for July of only $14.85,$0.59 below the farmer’s March shortposition of $15.44. Relative to keepingthe hedge in place, the dairy farmer lost$1.15 per hundredweight ($0.56 + $0.59)by lifting his hedge.

Moral: Don’t panic when faced withmargin calls if market fundamentalssupport your hedging decision. By lifting

a hedge, you risk ending up with a lowermilk price on top of a futures market loss.

When would I want to usea long hedge?Short hedges protect selling priceswhile long hedges protect purchase

prices. Dairy farmers can lock in part oftheir feed costs through a long hedgeusing corn or soybean meal futures. The mechanics of long hedges are thesame as for short hedges except that theinitial transaction is the purchase of acontract. But grain futures contracts aredeliverable contracts, so long hedgersneed to offset their contracts prior tomaturity. By hedging both milk andfeedstuffs, dairy farmers can protect anincome above their feed costs objective.

How is hedging used in cashforward contracting?In the earlier example, Dana Dairyused hedging directly to protect a milkprice objective. An alternative to directhedging is signing a cash forwardcontract offered by a plant for milk to bedelivered at some future date. Acceptinga cash forward contract is equivalent tohedging—you’re guaranteed the futurecash contract price regardless of what

happens to milk prices after you sign thecontract.

Cash forward contracting is especiallyuseful for producers who do not haveenough milk volume to make up a fullfutures contract (200,000 pounds permonth). Another advantage of cashforward contracting over direct hedgingis that you don’t have to worry aboutmargin calls.

The price offered in forward contractsis a base farm price, usually for milkwith specied butterfat, nonfat solids,and quality. Adjustments for milkcomposition differing from the standardare made when the milk is delivered andpremiums and discounts not relatedto federal order pricing rules are alsoapplied.

A disadvantage of cash forwardcontracting over direct hedging is thatyou have less control over your priceobjective. The price offered is a “take it orleave it” offer and cannot be withdrawn.If you deal in futures yourself, you canplace standing offers and offset hedgesafter they are placed. Another possibledisadvantage is that brokerage feesand other hedging expenses are builtinto the price offers in a cash forwardcontract. You may be able to get a betterdeal on your own.

Dairy plants offer a variety of cashforward contracts. Some offer xedprices for specic months, others offera single price for several months ofproduction, and still others offer aminimum price for a single month orseveral months. Let’s look at the simplestform, a xed price offer for one month.

Suppose that in May, Dana Dairycalls Bigcheese Coop and learns thatBigcheese will pay a base price (3.5percent butterfat, 2.99 percent protein,5.69 percent other solids, and 350,000SCC) of $16.10 for milk delivered inNovember. Milk differing from thebase composition will receive anadjusted price based on the federalorder component prices announced forNovember. Dana will also receive thefederal order Producer Price Differentialand will be eligible for other premiumsoutside the order that are normally paidby Bigcheese. By forward contracting,Dana projects the base price for milkof standard composition. Dana will stillreceive all of the premiums or discountsfrom the milk plant as before. Therefore,as with hedging the actual mailbox price,the price Dana will receive still dependsupon premiums and discounts paid, andin essence, there remains a basis risk aswith hedging.


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Dana decides to go with the offer andsigns a contract to deliver 200,000pounds of November milk to Bigcheeseat $16.10. While Bigcheese’s price is 10cents per hundredweight less than theNovember CME price Dana could getby selling the contract directly ($16.20),Dana doesn’t want to put money intoa broker account and lose sleep overpossible margin calls.

When Bigcheese gets Dana’s order, itconsolidates the 200,000 contractedpounds with the volume of milkcontracted by other producers forNovember on that day and places ashort hedge using the November futurescontract. The number of contractssold will be as close as possible tothe consolidated volume. Note thatBigcheese may have to wait a few daysto hedge a cash forward contract untilthere is enough consolidated volumeto make up a contract. This would resultin a loss to the plant if prices fell and again if prices rose between the time theproducer contract was signed and thehedge was placed.

The base price in Bigcheese’s forwardprice offer is actually the Class III price.So by placing a hedge, Bigcheese isfully protected from the Class III pricefalling below the price it offered toDana Dairy. The Coop doesn’t even haveto worry about basis risk, because it ishedging exactly the same “commodity”as represented by the futures contract. IfBigcheese did not hedge, it could end uppaying higher (contracted) prices for itsmilk than its competitors.

Suppose the Class III price does fallbetween May and November, ending upat $15.20. In that case, Bigcheese getsless for its cheese than it would havewith a $16.20 price, and thus, it wouldnot have the money to pay the contractprice. But having hedged, Bigcheesereceives $1.00 per hundredweight fromits futures market transaction to offset

the loss in cheese revenue. 9 So it hasthe money to pay the $16.10 contractedbase price to Dana Dairy and others whocontracted at that price.

If the Class III price rises between Mayand November, Bigcheese incurs a losson its futures market transaction equalto the change in price. Because it needsto cover that loss, Bigcheese cannotafford to pay more than the $16.10contracted price even though cheeseprices would indicate a higher price. Justlike in the case of direct hedging, DanaDairy will receive a lower price than dairyfarmers who did not contract.

Some dairy plants offer minimum

price contracts rather that xed pricecontracts. To protect themselves fromunfavorable price movements, plantswriting minimum price contractswould purchase put options, which arediscussed in the following section.

Plants that offer multi-month or annualxed price contracts would hedge byselling futures contracts equivalent involume to the volume contracted byproducers over the entire time periodof the contract. The contract price to

producers is based on the averagemonthly futures prices over the periodof the contract. While plants can protecttheir average price offer by placinghedges in several contract months,there is some risk due to price trends.For example, suppose a plant offers anannual $16.00 cash forward contract. The price is based on the average futurescontract price over the next 12 months. These prices range from $14.00 in therst month to $18.00 in the last. In therst month of the annual contract, theplant will likely need to borrow moneyor draw on its reserves to pay producersthe higher average price.

Part II: Optionson dairy futuresIn many ways, options trading is similar

to futures contract trading. The sameregulatory procedures generallyapply. Trading rules are similar. Thesame players are involved (hedgers,speculators, brokers, oor traders, locals,etc.). Placing trade orders is the same.

Trading options contracts is somewhatmore complicated than trading futures. There are more alternatives, moreconfusing terms, and a greater needto watch the markets. There are twoadvantages to using options instead

of futures for price risk management:(1) hedgers can preserve the benetsof favorable price movements whileprotecting themselves againstunfavorable movements; and (2) buyersof options don’t have to put up marginmoney or receive margin calls. But thereis a cost to gaining these benets in theform of options premiums.

What are futurescontract options?In a generic sense, the purchase of anoption gives the buyer the right topurchase something else. The right doesnot involve an obligation. Options arecommon in real estate markets. You buyan option to purchase property at anegotiated price. For example, you mightpay $2,000 for the right to purchase avacant lot in Madison, Wisconsin, fora price of $200,000 anytime before aspecied future date. If the real estatemarket in Madison goes up, you would

likely exercise your option and buy theproperty. If the market falls, you wouldlet your option expire.

9 Bigcheese’s futures market gain would be reduced by broker commissions, but these are covered by the 10 cents per hundredweightdiscount in the contract price relative to the selling price of the futures contract at the time Bigcheese places its hedge.


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What you pay for the real estate optiondepends on two factors: (1) the price ofthe property listed in the option relativeto its current value; and (2) generalexpecta tions with respect to real estatemarket conditions. If the current marketvalue of the property is $200,000 andthe price listed in the option is $250,000,then the option value would be muchsmaller than if the listed option price was$190,000. In a rising real estate market,you would expect to pay more for theoption to purchase the property at apre-negotiated price than you would in astagnant or falling market.

In any case, you can dispose of youroption in one of three ways. You canexercise the option and purchase theproperty. Or, you can let it expire. Thethird alternative is to sell the option tosomeone else, hopefully for a prot.

Futures contract options are similarto real estate options. You can buy acall , which is the right—but not theobligation—to purchase a futuresmarket contract at a specied price.You can then exercise the call, whichallows you to buy the underlying futurescontract at the set price. You can let thecall expire. Or, you can sell the call.

If the futures contract price risesabove the xed price in a call you havepurchased, you have an incentive toexercise your right to purchase thecontract at the lower price. Or, you couldsell the call if you were not interested intaking on the commitment to receivedelivery of the commodity. It is likelythat you could sell the call for more thanyou paid for it if the price of the futurescontract were increasing. If the futurescontract price falls below the xed pricein your call, you would likely let the callexpire; you would not want to buy thecontract at more than what it is currentlyselling for in the futures market.

The second type of futures contractoption is a put . A put is the right—butnot the obligation—to sell a futurescontract at a specied price. Like calls,put options are both bought and sold.Put buyers can exercise them, sellthem, or allow them to expire. If thefutures market price falls below theprice specied in the put, then it wouldnormally be protable for the buyerto either exercise or sell the put. If thefutures market price rises above theprice specied in the put, then the buyerwould normally allow the put to expire;you would not want to sell the futurescontract at less than what it is currentlyselling for in the futures market.

Both calls and puts have two essentialelements: (1) the futures contractdelivery or maturity month, and (2)the futures contract price (called thestrike price10). For example, a put optionto sell a November 2008 CME Class IIImilk contract at a price of $16.00 perhundredweight is denoted a November$16.00 put. A call option to buy aFebruary 2010 CME Class III milk contractat a price of $17.00 is a February $17.00call.

As in all markets, there have to be buyersand sellers on each side of the optionstransaction. Buyers of puts and calls arecalled option holders . The use of optionsfor hedging purposes typically involvesbuying calls and puts. Sellers of calls andputs are called option writers. Generally,option writers are speculators. Theyare speculating that the buyer will notexercise the option and that they willgain the premium collected. Call writersassume the obligation to provide along position in the underlying futurescontract if the holder decides to exercise;put writers are obligated to provide ashort position if the put is exercised.

What does it cost to buy afutures contract option? The price of an option is called its premium . The premium represents the

maximum amount the option holdercan lose. Premiums for puts and calls arerelated to two primary factors. The rstis the strike price relative to the currenttrading value of the underlying futurescontract. The difference is known as theintrinsic value of the option and is equalto the gross prot per unit that an optionholder could earn if the option wereexercised. The second factor affectingthe value of options is the length of timebetween the option transaction and the

expiration of the option contract. Thisaffects the time value of the option.

At any time, there will be trading inseveral options for the same contractmonth representing different strikeprices. Some strike prices will be abovethe current contract price, some below. The premium will be related to theeconomic benet of being able to buyor sell the contract at the strike price.For example, if in May, the price of aNovember CME Class III milk contract is

$16.20, a November $16.00 call wouldhave a premium of at least 20 cents. The right to buy a futures contract at 20cents less than its current value would beworth 20 cents or more. The call optionhas an intrinsic value of 20 cents and willhave additional time value.

A November $16.00 put in May wouldhave a smaller premium. The right tosell a November Class III milk futurescontract at less than its current valuewould have no intrinsic value, only time

value.

10 The strike price is sometimes called the striking price or the exercise price .


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Call options with strike prices below thecurrent futures price and put optionswith strike prices above the currentfutures price have intrinsic value. Thatis, there is a clear economic benet ofbeing able to purchase the contract atless than its current value (call) or sellit at more than its current value (put).Options that have intrinsic value arecalled “in the money”; those withoutintrinsic value are “out of the money”;and those with strike prices roughlyequal to the current futures contractprice are, not surprisingly, “at the money.” The more (deeper) in the money anoption, the higher will be the premium.

Out-of-the-money options usually havesome time value. We noted above thata November $16.00 put would havelimited value if the current Novemberfutures price were $16.20. This wouldbe especially true if we were talkingabout the value of the put in Octoberand the Class III milk futures market wasstable. But if the November $16.00 put ispurchased in January of the same year,then it could have considerable timevalue. The buyer is essentially payingfor nearly a year to see whether the

November futures contract price willfall below $16.00, thereby permitting aprot. In general, the more time betweenoption purchase and expiration, thehigher will be the premium.

Time value is also different at differentstrike prices. For example, at higher strikeprices, there is less of a chance that thecall option will come into the moneyduring the time prior to option expiring. Therefore, the time value will be lessthan for a call with a lower strike priceand a higher probability of coming intothe money.

Volatility in the price of the underlyingfutures contract also affects the timevalue of options contracts. If there arerapid and frequent price movementsfor a futures contract, then there is agreater likelihood that prices will moveto a level that will make exercising theoption protable than if futures pricesare relatively stable. Therefore, the optionwriter will want a larger premium fortaking a greater risk of having the optionexercised. In general, the greater thevolatility in futures prices, the greater thepremium for the options contract.

Table 3 illustrates quoted optionspremiums for the CME Class III milkcontract for July 2008 as of the end ofoor trading on February 13, 2008. OnFebruary 13, the July Class III futurescontract closed at $16.57, so the $16.50options are denoted as at the money. These indicated premiums are reported“settle” prices and may not representwhat the actual premium would havebeen if an actual trade had occurred.

Note the symmetry between the putand call premiums. At strike pricesbelow the current futures contractprice ($16.50), puts are increasinglyout of the money, so premiums fall.But calls are increasingly in the money,so premiums increase. At strike pricesabove the current futures contract price,puts are increasingly in the money andcalls are increasingly out of the money,meaning opposite changes in put andcall premiums.

Aren’t call and putoptions just two sidesof the same coin?Isn’t buying a put just the oppositeof selling a call? Absolutely not. Thedifference is in both the risk and thepotential gain involved. Using the valuesfrom table 3, let’s say you expect theClass III price to be less than $16.50by July. So you decide to sell an at-the-money July call option (a $16.50July call) on February 13 for $0.85 perhundredweight. The buyer of the call iswilling to pay $0.85 per hundredweightfor the right to buy the futures contract

at a price of $16.50 per hundredweightsometime between February 13 and theexpiration of the July call option. 11

Strikeprice($/cwt.)

Puts (cents/cwt.) Calls (cents/cwt.)

Premium

Intrinsicvalue

Timevalue

Premium

Intrinsicvalue

Timevalue

15.50 Out of themoney

42 0 42 In the money 141 107 34

15.75 50 0 50 125 82 39

16.00 60 0 60 110 57 53

16.25 71 0 71 98 32 66

16.50 At the money 83 — 83 At the money 85 — 85

16.75 In the money 97 18 79 Out of themoney

74 0 74

17.00 110 43 67 64 0 64

17.25 126 68 58 55 0 55

17.50 131 93 38 48 0 48

Table 3 .Decompositionof the July 2008Class III milkoptions premiums(based on futures

market settlementprice of $16.57 onFebruary 13, 2008)

11 Options on cash-settled dairy futures contracts expire on the day before the USDA monthly price announcement, which is the Friday on or beforethe 5th of the month following the contract month.


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Now, let’s suppose that June rolls around,and you nd out that you were deadwrong. The July Class III milk futurescontract is trading at $18.50. The buyerof the call option that you sold decidesto exercise and is placed in a longposition in the futures market for oneJuly Class III milk futures contract at the$16.50 strike price. As the writer of thecall that was exercised, you are placedon the opposite side of the transactionand are now short one July Class IIImilk futures contract at the $16.50strike price. To offset your short futuresposition, you buy one July contract at thecurrent price of $18.50. 12 You lose $2.00per hundredweight. What looked like a

good bet and a prot of $1,700 turnedinto a loss of $2,300, not includingcommissions ($4,000 futures market lossminus $1,700 premium collected).

But what if you had bought a put insteadof selling a call? By purchasing an at-the-money put, you gain the right to sell theJuly Class III milk contract at $16.50 perhundredweight. From table 3, the cost ofthis right to sell, the put premium, is $0.83per hundredweight. By buying a put, youare banking on a milk price decline, just

as you are when you sell a call.

But there’s a big difference. Come June,when the July Class III milk futuresprice has jumped to $18.50, the valueof your put option has dropped to zero;nobody is very interested in selling theJuly futures contract for $16.50 whenthey can sell it for $18.50 in the futuresmarket. So you’re out your $1,660 inpremium money. But, unlike the calloption case, that’s all you’ve lost. Yourput option is worthless, but you havenot risked the potentially large lossesassociated with selling a call.

How would you fare as a call seller andput buyer if your price predic tion hadbeen correct? Let’s assume that nearthe expiration of the options, the JulyClass III milk futures price is $14.00 perhundredweight. The call option—theright to buy the futures contract at$16.50—is worthless, and the buyer letsit expire. The put option is now tradingat $2.50 or more—it’s worth at least$2.50 per hundredweight to be able tosell the futures contract for $2.50 morethan its current value. You can eithersell your put and pocket your prot of$3,340 ($5,000 option gain minus $1,660premium paid), or you can just wait until

the option expires.

The same difference applies to buyingcalls and selling puts if a futures marketprice increase is expected. The generalprinciple is: Buyers of puts and callsface unlimited gains and limited losses(the option premium). Sellers of putsand calls face limited gains (the optionpremium) and unlimited losses.

Despite the risks associated with writingcalls, there are cases where hedgers canreduce this risk and sell calls as part of apackage of price risk management tools.Examples are provided in appendix II.

What do the options ondairy futures look like?Since puts and calls are options to selland buy a futures contract, most of thespecications for the options contractsare identical to the specications forthe underlying futures contract. For thedairy options, the price quotation, lasttrading day, and position limits matchthe futures. There are no daily price limitsspecied for option premiums. But sincethe value of puts and calls changes withthe value of the futures contract, thedaily price limits for futures contracts

effectively establish limits on changes inoption premiums.

Contract specications that are uniqueto options are shown in table 4.

With the exception of the Midsize ClassIII milk options, the options contracttrading unit is the futures contracttrading unit. The Midsize Class III optionsare one-half the Class III futures contractvolume. These options provide betterhedging opportunities for producerswho market less than 200,000 pounds

per month. The American exercise method allowscall and put holders (buyers) to exercisetheir options at any time. Under theEuropean method, exercise is onlypermitted on the last day of trading.

Options contract Trading unitStrike price

interval (cents)Exercisemethod

Class III milk 2,000 cwt. 25 American

Midsize Class III milk 1,000 cwt. 25 European

Class IV milk 2,000 cwt. 25 American

Nonfat dry milk 44,000 lbs. 2/1 in nearest

contract month

American

Dry whey 44,000 lbs. 2/1 in nearestcontract month

American

Deliverable butter 40,000 lbs. 2 American &European

Cash-settled butter 20,000 lbs. 2 American

Table 4. Dairy options contract specications

12 If the call is exercised, writers are not obligated to immediately offset their short futures market position. They may hold on to their shortposition in hopes of a price decline and a resulting lower cost of offsetting.


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Options on cash-settled futurescontracts are also cash settled againstthe announced settlement price. Thatis, if the option is in the money at thetime of settlement, then holders (buyers)automatically receive the differencebetween the announced price and thestrike price of their option and writers(sellers) pay the difference. For instance,the buyer of a $16.00 CME Class IIImilk put who did not exercise prior toexpiration would receive a paymentat the expiration of the option if theannounced Class III price were less than$16.00. The payment per put optioncontract would be equal to $16.00minus the announced price times 2,000.

Similarly, the buyer of a $16.00 call wouldreceive a payment if the announcedClass III price were higher than $16.00.

Because of the cash settlement methodfor most dairy options, there is usuallyno benet to exercising an in-the-moneyoption. Remember that exercising anoption means the holder will be placedin a short (put) or long (call) position infutures at the option strike price. Thefutures position will be cash settledagainst the announced price at contract

maturity. So the return to the optionholder who exercises will be exactly thesame as the return to the holder whowaits until maturity and cash settlesthe option.

How can options be usedfor hedging price risk?Like futures trading, options tradingcan shift the risk of unfavorable price

movements in the cash market tospeculators. The difference is thathedgers using options can lock inminimum or maximum price objectives(subject to the same basis risk thatapplies to futures market hedging) andsimultaneously benet from favorableprice movements. However, thereis a cost to achieve this asymmetricprotection in the form of the optionspremium. There is no such premiuminvolved in futures market hedging.

Purchasing an option can be viewedas buying price protection insurancefor future cash market transactions. The insurance premium is the optionpremium. If you don’t need the insurance(prices move in your favor), you stillpay the premium. If you do need theinsurance (prices move against you),then the insurance pays off in the formof helping to ensure a price or protobjective by offsetting cash marketlosses with options market gains.

The insurance analogy can be carriedfurther to look at purchasing optionsat different strike prices. When you buyautomobile insurance, you can selectfrom different deductibles for thecollision and comprehensive portionsof the package. If you choose a zeroor very low deductible, then your costwill be relatively high in comparisonto choosing, say, a $1,000 deductible.By choosing a high deductible, youare limiting your risk, but, at the same

time, you are self-insuring up to thedeductible amount. In other words, youare willing to bear part of the cost ofhaving a wreck but not all of it.

If you buy at-the-money options toprovide price protection, then you willpay more than if you buy put or calloptions that are out of the money. An at-the-money option is the same as a zerodeductible insurance policy; it protects

the current futures contract price. Anout-of-the-money option will cost less. The further out of the money, the smallerthe premium. But, at the same time, theout-of-the-money option will protect aprice objective that is less than (put) orgreater than (call) the current futurescontract price. There is a “deductible”representing the willingness of thepurchaser to self-insure the differencebetween the strike price and the currentfutures contract price.

To illustrate the use of put options toprotect against a price decline, supposeit’s June and you expect to sell 200,000pounds of milk in November. Yourreading of dairy outlook informationmakes you worried about a pricecollapse between June and November.You think that the June price of $16.00for the November Class III milk futurescontract is not likely to hold. You’veestimated your full costs of productionat $15.70 per hundredweight andthe ve-year average basis for yourfarm is +$1.30 per hundredweight forNovember. So you need a Class III priceof $14.40 to cover your costs.

The $15.00 (out-of-the-money) putoption for the November Class III milkcontract is trading at $0.50. You decide tobuy one November $15.00 put and placethe order with your broker. The brokergets the trade at $0.50 and charges you$60.00, or 3 cents per hundredweight, asa commission.

By purchasing the November $15.00 put,you’ve established a price oor of $15.77($15.00 strike price + $1.30 basis – $0.50premium – $0.03 commission). This is7 cents above your cost of production.You have paid a premium of $1,000to ensure your price objective. That isyour maximum liability in the optionsmarket. If the November Class III priceis announced at $15.00 or higher, yourput option will expire worthless, inwhich case you are out $1,000. If theannounced Class III price is less than$15.00, you will garner a prot equalto $15.00 minus the announced price,


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which you can use to supplement yourlower cash market milk price. Your hopeis that the option will expire worthless,which will mean that your cash marketprice objective will be exceeded.

Let’s use some specic examples.Suppose you were correct in yourpessimistic forecast for the NovemberClass III price, and it is announcedat $14.30. Your milk plant pays you$15.60 for the milk that you deliveredin November, which means your basisforeca

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